A Coverdell Education Savings Account (ESA) 26 USC §530 formerly known as an Educational IRA, is an account created as an incentive to help parents and students save for education expenses.

The total contributions for the beneficiary (Child – Grandchild) of this account cannot be more than $2,000 in any year, no matter how many accounts have been established. A beneficiary is someone who is under age 18 or is a special needs beneficiary. This might change to $500 in 2013? Fiscal Cliff and all.

Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to qualified higher education expenses as well as to qualified elementary and secondary education expenses.

Here are some things to remember about Distributions from Coverdell Accounts:

Distributions are tax-free as long as they are used for qualified education expenses, such as tuition and fees, required books, supplies and equipment and qualified expenses for room and board.

There is no tax on distributions if they are for enrollment or attendance at an eligible educational institution. This includes any public, private or religious school that provides elementary or secondary education as determined under state law. Eligible institutions also include any college, university, vocational school or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. Virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions are eligible.

The Hope and lifetime learning credits can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits.

If the distribution exceeds qualified education expenses, a portion will be taxable to the beneficiary and will usually be subject to an additional 10% tax. Exceptions to the additional 10% tax include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship.

There are contribution limits for taxpayers based on the contributor’s Modified Adjusted Gross Income. Contributions to a Coverdell ESA may be made until the due date of the contributor’s return, without extensions.

If there is a balance in the Coverdell ESA when the beneficiary reaches age 30, it must generally be distributed within 30 days. The portion representing earnings on the account will be taxable and subject to the additional 10% tax. The beneficiary may avoid these taxes by rolling over the full balance to another Coverdell ESA for another family member. For more details, see Publication 970, Tax Benefits for Higher Education (PDF)

Non-deductible child education expenses can’t be transformed into deductible expenses by virtue of assigning assets or income to a trust, partnership, or other entity. Any investment scheme that claims to allow you to deduct these types of expenses should be considered highly suspect. Source IRS

An Education IRA (EIRA) is an IRA established to provide funds that will allow your child – grandchild to attend University. It’s been replaced by the Coverdell Education Savings Account, we are currently updating this page.